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An Economical Business-Cycle Model

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  • Emmanuel Saez

    (UC Berkeley)

  • Pascal Michaillat

    (London School of Economics)

Abstract

We construct a microfounded, dynamic version of the IS-LM-Phillips curve model by adding two elements to the money-in-the-utility-function model of Sidrauski (1967). First, real wealth enters the utility function. The resulting Euler equation describes consumption as a decreasing function of the interest rate in steady state–the IS curve. The demand for real money balances describes consumption as an increasing function of the interest rate in steady state–the LM curve. The intersection of the IS and LM curves defines the aggregate demand (AD) curve. Second, matching frictions in the labor market create unemployment. The aggregate supply (AS) curve describes output sold for a given market tightness. Tightness adjusts to equalize AD and AS curve for any price process. With a rigid price process, this steady-state equilibrium captures Keynesian intuitions. Demand and supply shocks affect tightness, unemployment, consumption, and output. Monetary policy affects aggregate demand and can be used for stabilization. Monetary policy is ineffective in a liquidity trap with zero nominal interest rate. In contrast, with a flexible price process, aggregate demand and monetary policy are irrelevant when the nominal interest rate is positive. In a liquidity trap, monetary policy is useful if it can increase inflation. We discuss equilibrium dynamics under a Phillips curve describing the slow adjustment of prices to their flexible level in the long run.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2014 Meeting Papers with number 105.

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Date of creation: 2014
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Handle: RePEc:red:sed014:105

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References

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  1. Gauti B. Eggertsson, 2009. "What fiscal policy is effective at zero interest rates?," Staff Reports 402, Federal Reserve Bank of New York.
  2. Pascal Michaillat & Emmanuel Saez, 2013. "A model of aggregate demand and unemployment," LSE Research Online Documents on Economics 51579, London School of Economics and Political Science, LSE Library.
  3. James Tobin, 1991. "Price Flexibility and Output Stability: An Old Keynesian View," Cowles Foundation Discussion Papers 994R, Cowles Foundation for Research in Economics, Yale University, revised Sep 1991.
  4. Pascal Michaillat & Emmanuel Saez, 2014. "Aggregate Demand, Idle Time, and Unemployment," Discussion Papers 1419, Centre for Macroeconomics (CFM).
  5. Hosios, Arthur J, 1990. "On the Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Wiley Blackwell, vol. 57(2), pages 279-98, April.
  6. Heng-fu Zou, 1998. "The spirit of capitalism, social status, money, and accumulation," Journal of Economics, Springer, vol. 68(3), pages 219-233, October.
  7. Gauti B. Eggertsson & Paul Krugman, 2012. "Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach," The Quarterly Journal of Economics, Oxford University Press, vol. 127(3), pages 1469-1513.
  8. Pascal Michaillat, 2012. "Do Matching Frictions Explain Unemployment? Not in Bad Times," American Economic Review, American Economic Association, vol. 102(4), pages 1721-50, June.
  9. Heng-fu Zou, 1995. "The spirit of capitalism and savings behavior," Journal of Economic Behavior & Organization, Elsevier, vol. 28(1), pages 131-143, September.
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  1. The best justification for IS-LM?
    by Economic Logician in Economic Logic on 2014-01-29 15:45:00

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